This document summarizes key concepts about how governments intervene in markets through policies like price controls, taxes, and how the impacts of these policies depend on supply and demand elasticities. Specifically: 1) Price controls like ceilings can cause shortages by creating a situation where demand exceeds supply. Price floors can cause surpluses by making supply exceed demand. 2) Taxes shift the supply curve up and demand curve left, changing market equilibrium. The burden of taxes depends on price elasticities - the less elastic side bears more of the burden. 3) Governments tend to tax necessities more due to their inelastic demand yielding more revenue, even though luxuries with elastic demand are more popular to tax

1. 1
SUPPLY, DEMAND, AND
GOVERNMENT POLICIES
Chapter 6

2. 2
What we learn now?
• In Ch.2 we mentioned two roles for economists:
– As scientists they try explain the world
– As policymakers they try to change the world
• Ch.4 and Ch.5 analysed objectively how supply and
demand works in markets
• In Ch.6 we analyse various types of government
policy towards the markets
• To that purpose we will only use tools of supply and
demand that we just developed
• The analysis will yield some surprising insights
about how markets work
• Common sense and economic analysis may give
opposing advise to policymakers

3. 3
Supply, demand, and government
• In a free, unregulated market system, market forces
establish equilibrium prices and quantities
• The market equilibrium may be efficient, but it may
not leave everyone satisfied
• Those who consider themselves to be losing from
the market outcomes will ask for government to
intervene in the market
• The government intervention in the markets may
take several ways, depending on the circumstances
• We will look at two different cases of direct
government involvement in markets:
– Price controls
– Taxes levied on goods and services

4. 4
Price controls
• Price control: government sets an upper or lower
limit (or both) to the price of good or service
• Price controls are often used in many countries
• Price controls are enacted by governments because
there is a demand for them from some sections of
the public
• Who, either as buyers or sellers feel that the existing
market price is unfair to them
• We will distinguish between two types of controls
• Price Ceiling: a legally established maximum price
at which a good can be sold.
• Price Floor: a legally established minimum price at
which a good can be sold

5. 5
Price ceilings
• Price ceilings limit the maximum price that sellers
can charge to their customers
• In other words, market price can be lower but can
not be higher than the price fixed by government
• Two outcomes are possible when the government
imposes a price ceiling
• The price ceiling is not binding if it is set above the
equilibrium price
• It will have no impact on the market
• The price ceiling is binding if it is set below the
equilibrium price
• It will lead to shortages in the market as demand
exceeds supply at that price

6. A price ceiling that is not binding
$4
3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
100
Equilibrium
quantity
Price
ceiling
Equilibrium
price
Demand
Supply

7. A price ceiling that is binding
$3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
2
Demand
Supply
Price
ceiling
Shortage
75
Quantity
supplied
125
Quantity
demanded
Equilibrium
price

8. 8
Effects of price ceilings
• A price ceiling prevents the price to rise further even
if demand is high
• A binding price ceiling creates shortages because
QD > QS.
• Example: there was a margarine shortage in Turkey
during 1978-79 crisis because the price was fixed
too low to cover the costs of producers
• Shortages result in non-price rationing such as long
lines in front of the shops, discrimination by sellers
and as a rule the formation of a “black market”
• In Turkey there was a black market for dollars
before 1980s because the government had fixed the
exchange rate below the market equilibrium rate

9. 9
(a) The Price Ceiling on Gasoline Is Not Binding
Quantity of
Gasoline
0
Price of
Gasoline
(b) The Price Ceiling on Gasoline Is Binding
P 2
P 1
Quantity of
Gasoline
0
Price of
Gasoline
Q 1
Q D
Demand
S 1
S 2
Price ceiling
Q S
4. ...
resulting
in a
shortage.
3. ...the price
ceiling becomes
binding...
2. ...but when
supply falls...
1. Initially,
the price
ceiling
is not
binding... Price ceiling
P 1
Q 1
Demand
Supply, S 1
Price ceiling on gasoline
A fall in supply turns an unbinding price ceiling
into a binding ceiling and causes shortages of
gasoline

10. 10
(a) Rent Control in the Short Run
(supply and demand are inelastic)
(b) Rent Control in the Long Run
(supply and demand are elastic)
Quantity of
Apartments
0
Supply
Controlled rent
Shortage
Rental
Price of
Apartment
0
Rental
Price of
Apartment
Quantity of
Apartments
Demand
Supply
Controlled rent
Shortage
Demand
Rent control: short and long run
Controling rents cause bigger shortages in the
long run because new construction becomes
unattractive, reducing long run supply

11. 11
Price floors
• Price floors set the minimum price that buyers must
pay for a product
• Market price can be higher but not below the price
set by the government
• When the government imposes a price floor, again
two outcomes are possible
• The price floor is not binding if it is set below the
equilibrium price
• It has no effect on the market
• The price floor is binding if it is set above the
equilibrium price
• It leads to a surplus because demand is less than
supply at that price

12. 12
A price floor that is not binding
$3
2
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
100
Equilibrium
quantity
Price
floor
Equilibrium
price
Demand
Supply

13. 13
A price floor that is binding
$4
Quantity of
Ice Cream
Cones
0
Price of
Ice Cream
Cones
3
Demand
Supply
Price floor
80
Quantity
demanded
120
Quantity
Supplied
Equilibrium
price
Surplus

14. 14
Effects of a price floor
• A price floor prevents price to fall even if demand is
very low
• When the market price hits the floor, it can fall no
further, and the market price equals the floor price
• A binding price floor causes a surplus of supply
over demand because at that price
QS > QD.
• Agricultural support prices are typical examples
• When set above market levels, they result in large
unsold stocks (tobacco?)
• Minimum wage laws also set price floors for wages
• Binding minimum wages prevent wages to go down
and therefore cause unemployment

15. 15
(a) A Free Labor Market
Quantity of
Labor
0
Wage
Equilibrium
employment
(b) A Labor Market with a Binding Minimum Wage
Quantity of
Labor
0
Wage
Quantity
demanded
Quantity
supplied
Labor
supply
Labor
demand
Minimum
wage
Labor surplus
(unemployment)
Equilibrium
wage
Labor
demand
Labor
supply
Minumum wage law and employment
Minimum wage legislation increases both the real
wage of employed and the number of unemployed

16. 16
Taxes: impact
• Taxes levied on goods and services are called
indirect taxes
• The amount of tax fixed by the government is added
to the price and paid everytime the good is sold
• Taxes discourage market activity
• When a good is taxed, the quantity sold is smaller
• Buyers and sellers share the tax burden
• Tax incidence is the study of who bears the burden
of a tax
• Taxes result in a change in market equilibrium
• Buyers pay more and sellers receive less, regardless
of whom the tax is levied on

17. Impact of a 50¢ tax on buyers
3.00
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
100
D1
Supply, S1

18. Impact of a 50¢ tax on buyers
$3.30
3.00
2.80
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
Price
sellers
receive
100
90
Equilibrium
with tax
Equilibrium without tax
Price
buyers
pay
D1
D2
Supply, S1

19. Impact of a 50¢ tax on sellers
3.00
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
100
S1
Demand, D1

20. Impact of a 50¢ tax on sellers
$3.30
3.00
2.80
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
Price
without
tax
Price
sellers
receive
100
90
Equilibrium
with tax
Equilibrium without tax
Tax ($0.50)
Price
buyers
pay
S1
S2
Demand, D1
A tax on sellers
shifts the supply
curve upward by
the amount of
the tax ($0.50).

21. 21
The incidence of tax
• Tax incidence tries to establish who pays the tax in
the end?
• In other words, in what proportions is the burden of
the tax divided between buyers and sellers?
• Alternatively, how do the effects of taxes on sellers
compare to those levied on buyers?
• This is an opportunity for us to see how the measure
of elasticity can be used in economics
• Because the answers to these questions depends on
the elasticity of demand and the elasticity of supply.
• We shall show that the burden of a tax falls more
heavily on the side of the market that is less elastic

22. 22
Elasticity and tax incidence
• Elasticity enters the picture because total revenue in
the market depends on the price elasticity of demand
and price elasticity of supply
• We can distinguish among three major cases
– If demand is inelastic while supply is elastic, then
a larger share of the tax will fall on the buyers
– If demand is elastic while supply is inelestic, then
a larger share of the tax will fall on the sellers
– If demand and supply are unit elastic, buyers and
seller will share the tax burden equally
• The government is able to target correctly those
whom it wishes to pay the tax when the price
elasticities of demand and supply are known

23. 23
Elastic supply, inelastic demand
Quantity
0
Price
Demand
Supply
Price without tax

24. 24
Elastic supply, inelastic demand
Quantity
0
Price
Demand
Supply
Tax
2. ...the
incidence of the
tax falls more
heavily on
consumers...
1. When supply is more
elastic than demand...
3. ...than on
producers.
Price sellers receive
Price buyers pay
Price without tax

25. 25
Inelastic supply, elastic demand
Quantity
0
Price
Demand
Supply
Price without tax

26. 26
Inelastic supply, elastic demand
Price without tax
Quantity
0
Price
Demand
Supply
Tax
Price sellers receive
Price buyers pay
2. ...the
incidence of
the tax falls more
heavily on producers...
3. ...than on consumers.
1. When demand is more
elastic than supply...

27. 27
Taxing luxuries or necessities?
• There is always a demand from the public to tax
luxuries but not necessities
• Taxing goods that are considered luxuries is popular
both with the public and governments
• Unfortunately luxury goods usually have high price
elasticity of demand (bigger than 1)
• Therefore taxes reduce the consumption of luxuries
• Tax revenue is much lower than expected
• In turn, necessities have low price elasticity of
demand (smaller than 1)
• And yield high tax revenues to the government
• In order to obtain revenues the government ends up
by taxing necessities in Turkey

28. 28
Conclusion
• The economy is governed by two kinds of laws:
– The laws of supply and demand.
– The laws enacted by government
• Prices can be controled by ceilings or floors
• Price ceilings cause shortages and black market
• Price floors result in surpluses and unsold stoks held
by the government
• Taxes raise revenue to the government
• Taxes create new price equilibriums in which buyers
and sellers share the tax
• The incidence of the tax depends on the price
elasticity of demand and supply
• Necessities are taxed to get more revenue